Suppose that you are examining a company as a potential acquisition target. Your analyst did a DCF analysis, and you know that the company has a total (enterprise) value of $150 million. Your analyst looked at the numbers over time, and estimated that the volatility of its assets is 15%. You want to put in an offer to purchase all of the equity of the company, because that would give you control. The company has (zero-coupon) risky debt outstanding with a principal amount of $70 million. All of the debt is due in 2 years, and it all has the same seniority. The current risk-free interest rate is 1%. 1

(a) Draw a payoff diagram of the company's equity and debt as a function of the company's asset value in 2 years (i.e. the maturity of the debt). (Draw them on the same graph)

(b) What is the value of the company's equity, given the amount of debt it has outstanding? (You may use a Black-Scholes-Merton calculator)

(c) Before you are able to make your offer to purchase the company's equity, the company announces that it is splitting its debt into two different seniorities. It will now have senior debt with an outstanding principal amount of $30 million, and junior debt with an outstanding principal amount of $40 million. Draw a payoff diagram of the company's senior debt and junior debt as a function of the company's asset value in 2 years. (Draw them on the same graph)

(d) You wonder whether the company's decision should affect your offer. What is the market value of the company's equity after the company splits its debt? Compare your answer to part (b), and explain.

(e) What is the market value of the company's junior debt?

(f) What is the market value of the company's senior debt?